1. Why Risk Arises - The Custody Model

Most exchanges operate on custodial model: you deposit cash/crypto/securities, exchange credits you in internal ledger, but legal title / control is with exchange.

Risk arises when:

a) Commingling: Exchange pools customer funds with its own funds in same bank account / wallet.
b) Rehypothecation / Re-use: Exchange lends, pledges, invests customer assets for its own profit without express consent.
c) No Trust / No Segregation: Terms of Service say customer is granting title to exchange, creating debtor-creditor relationship, not bailment/trust.
d) No Client Money Rules: Unlike regulated brokers, crypto exchanges historically did not follow CASS 7 (UK) or SEC Rule 15c3-3.

When insolvent, question for court is: Is the asset customer property held in trust for return, or property of estate to be distributed pro-rata to all creditors?

2. Legal Frameworks

USA - Securities:

• Securities Investor Protection Act (SIPA) 1970: When broker fails, SIPC appoints Trustee to liquidate. Under 11 U.S.C. § 741-753 - Stockbroker liquidation. Customer property must be returned first, before general creditors. SIPC advances up to $500k per customer.
• Rule 15c3-3 - Customer Protection Rule: Broker must segregate fully paid securities.

USA - Commodities:

• 11 U.S.C. § 766 - Commodity broker liquidation - customer property in commodity accounts gets priority.

UK - FCA CASS:

• CASS 7 - Client Money Rules: Requires client money be held on trust, segregated in client bank accounts, reconciled daily.
• Failure to follow = trust still arises but distribution becomes complex - Lehman Brothers International (Europe) v CRC Credit Fund Ltd [2012] UKSC 6 - Supreme Court held CASS trust arises on receipt, not just on segregation, but pooling principle applies.

EU: MiFID II Article 16(8)-(10), CSDR - segregation requirement. EMIR for derivatives.

India:

• Stock Exchanges: SEBI Stock Brokers Regulations, Client segregation, Investor Protection Fund (IPF) of NSE/ BSE up to Rs 25 lakhs per client.
• Crypto: No specific segregation law, falls under IBC 2016 - customer treated as unsecured financial creditor unless trust proved.
• IBC Section 36(4) - assets held in trust by corporate debtor for third party do NOT form part of liquidation estate - but trust must be proved.

3. Traditional Exchange / Broker Case Law

1. In re Lehman Brothers Inc. - SIPA Liquidation 2008-2018 - James W. Giddens Trustee
Lehman Brothers Inc. (LBI) - brokerage arm collapsed. Trustee appointed to liquidate and return customer property under SIPA.
Issues: What is "customer property"? Claimants who held securities as collateral argued they are customers.
In In re Lehman Brothers Inc., 462 B.R. 53 (Bankr. S.D.N.Y. 2011) - Judge Peck, held claims for return of collateral held by LBI for proprietary trading are NOT securities customer claims - reclassified as general creditor claims. Principle followed in later cases.
Customer property returned - $110bn+ returned, but customers with complex prime brokerage arrangements had to fight.

2. In re MF Global Inc., 515 B.R. 434 (Bankr. S.D.N.Y. 2014) and MF Global UK Ltd EWHC
Largest Wall Street collapse after Lehman. MF Global, registered as broker-dealer and FCM, misused ∼$1.6bn customer funds to cover proprietary bets on European sovereign debt.

• US: SIPA Trustee - customers of futures commission merchant have priority but due to commingling shortfall, customers suffered 10% haircut initially, later recovered 100% after litigation.[2013]
• UK: First major case illustrating Lehman UKSC 6 principle. Court of Appeal held CASS 7 trust applied - client money received by MFG UK was held on trust for clients, distribution pro-rata among all clients who contributed, even if money not yet segregated. Application by Administrators of MF Global UK Ltd for directions on client money trust.

Principle: Failure to segregate does not defeat client trust, but creates pooling.

3. In re Bernard L. Madoff Investment Securities - SIPA
Ponzi scheme. Customer claims based on last statement vs net equity method. Supreme Court affirmed Trustee's net equity method - customers only entitled to cash in minus cash out.

4. Crypto Exchange Case Law - The New Frontier

4. Mt. Gox Co. Ltd., Tokyo District Court 2014 - Bankruptcy 2014
Once largest bitcoin exchange - filed after losing 850,000 BTC, 750,000 belonging to customers. Japanese law treated BTC as not property but claim. Customers filed as unsecured creditors valued in Yen at 2014 price (∼$483 per BTC). Repayments started July 2024, pushed to Oct 2027 - customers waited 10 years and get fixed Yen value, not BTC appreciation. Established first risk: Customer crypto is estate property if no trust.

5. In re Celsius Network LLC, Case No. 22-10964 (Bankr. S.D.N.Y. 2022) - Earn Accounts Ruling - Judge Martin Glenn - Jan 4, 2023
Most important precedent.
Celsius offered "Earn" accounts - deposit crypto, earn up to 17% interest, Celsius could rehypothecate.
Celsius filed Chapter 11 July 2022 - owed users $4.7bn, had $167m cash.
Key question: Who owns crypto in Earn accounts?
Held: Terms of Use Version 8 clearly stated title to coins transfers to Celsius, and Celsius has right to use, sell, pledge. Therefore assets in Earn accounts are property of the estate under 11 U.S.C. § 541, customers are unsecured creditors. Earn customers get 65-85% recovery over years, not return of coins.
Established critical precedent: Contract language controls - if ToS says title transfers, no trust.

6. In re Voyager Digital Holdings, Inc., No. 22-10943 (Bankr. S.D.N.Y.) - July 2022
Brokerage - customer dollars held in FDIC-insured account at Metropolitan Commercial Bank. Voyager claimed dollars FDIC insured.
Court: FDIC insurance covers failure of Metropolitan Bank, NOT failure of Voyager. Customers discovered they are unsecured creditors for crypto, only USD cash held in For Benefit Of (FBO) account returned. 35% recovery initially.

7. In re FTX Trading Ltd., No. 22-11068 (Bankr. D. Del.) - Nov 2022 - John J. Ray III
FTX collapsed with ∼$8bn customer funds missing. Alleged fraud - Alameda Research used customer funds.
Key rulings in progress:

• Customer property vs estate: Court distinguished - crypto held in custodial wallets segregated and traceable may be customer property, but commingled and used for proprietary trading becomes estate property.
• Preference actions: Customers who withdrew $5bn on eve of bankruptcy subject to clawback under 90-day preference - Clawback to the Future doctrine.
• Valuation: Claims valued in dollars on petition date, not in crypto - so BTC at $17k, not current $60k+ - similar to Mt. Gox problem.
• Recovery estimated 96-120% in dollar terms due to crypto appreciation, but customers lose upside.

8. In re BlockFi Inc. and In re Three Arrows Capital (3AC) - 2022 Cascade
3AC invested $200m in Luna, collapse dragged Voyager (owed $650m unsecured), BlockFi, Genesis. Court held crypto lent to 3AC is unsecured loan, not custodial - no return priority.

5. Test to Determine Risk - How Indian Courts Will Apply

Under Indian law, to claim customer assets are NOT part of liquidation estate under IBC Sec 36(4), customer must prove:

1. Express Trust: Agreement says assets held in trust / segregated / on fiduciary basis, not title transfer.
2. Segregation in Fact: Blockchain analysis / bank statements show separate wallet / account, no commingling.
3. No Rehypothecation Right: Exchange did not have right to lend / pledge.
4. Tracing: Asset identifiable - e.g., specific BTC UTXO, not pooled.

If any fails - as in Celsius ToS - Indian NCLT will treat customer as Financial Creditor under Sec 5(7) IBC, file claim in Form C, recovery in waterfall under Sec 53 - after insolvency costs, secured creditors, workmen.

SEBI Protection for Stock Brokers: For NSE/ BSE broker default, IPF pays up to Rs 25 lakhs per client after verifying client code, ledger, and segregation. This does not exist for crypto.

6. Mitigation for Customer

• Read ToS - does title transfer? Look for "we may rehypothecate".
• Prefer exchanges with CASS-like segregation - proof of reserves, segregated wallets, trust structure.
• Self-custody for long term - "Not your keys, not your coins".
• For Indian users trading on foreign crypto exchanges - jurisdiction risk - filing claim in Delaware bankruptcy requires US counsel.
• For stock broker - ensure POA not given for unlimited transfer, check SEBI SCORES.